At the beginning of a given trading period, the nominal exchange rate between the Nigerian… — JAMB UTME

At the beginning of a given trading period, the nominal exchange rate between the Nigerian Naira ( $\text{NGN}$ ) and the US Dollar ( $\text{USD}$ ) is $\$1 = \text{NGN } 500$ . During the period, Nigeria records an annual inflation rate of $26\%$ , whereas the United States records an annual inflation rate of $5\%$ . According to the relative Purchasing Power Parity (PPP) theory of exchange rate determination, what is the new equilibrium nominal exchange rate in $\text{NGN}$ per $\text{USD}$ ?

Answer: 600 NGN/USD

Answer

The new equilibrium nominal exchange rate is 600 NGN per USD.

Under relative Purchasing Power Parity, an inflation differential between two trading partners leads to a proportional depreciation of the currency with higher inflation. Dividing the domestic price index factor (1.26) by the foreign price index factor (1.05) yields an adjustment multiplier of 1.20. Multiplying the initial rate of 500 NGN/USD by 1.20 gives 600 NGN/USD.

Step-by-Step Solution

Identify the relative Purchasing Power Parity (PPP) formula for exchange rate adjustment based on inflation differentials.

Formula:

E_1 = E_0 \times \frac{1 + i_{\text{domestic}}}{1 + i_{\text{foreign}}}

Relative PPP states that exchange rates change to offset differences in inflation rates between two nations.

Substitute the initial rate (500), domestic inflation (0.26), and foreign inflation (0.05) into the equation.

E_1 = 500 \times \frac{1.26}{1.05}

This adjusts the currency valuation proportionally to the change in relative purchasing power.

Perform the division and multiplication.

E_1 = 500 \times 1.20 = 600

Evaluating the expression yields the depreciated exchange rate for the domestic currency.

Key Concept

Purchasing Power Parity (PPP) and Exchange Rate Determination

Estimated Time:2m 0s

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